For much of the past year, and even beyond, the legal-weed industry and marijuana stocks have been practically unstoppable.
According to Marijuana Business Daily's latest report titled "Marijuana Business Factbook 2017," U.S. legal pot sales are expected to grow by approximately 30% in 2017, and by an estimated 300% between 2016 and 2021 to around $17 billion. Investors clearly want in on this growth, which is why we've seen so many pot stocks rally by 100% or more over the trailing year.
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Of course, growth opportunities exist beyond the U.S., even if the market for marijuana in the United States is seen as more robust than most other countries. For instance, Mexico wound up legalizing medical cannabis earlier this year, and Prime Minister Justin Trudeau of Canada introduced a bill in April that could legalize recreational marijuana for adults ages 21 and up by July 1, 2018. We know from polls by Gallup and CBS News that support for legalization is there (at least in the U.S.) -- it's just a matter of figuring out which U.S. states or which countries could be next.
Two figures all marijuana investors should know
Investing in marijuana stocks won't remain as easy as throwing a dart for long. Though you could almost have closed your eyes and picked a winner over the past year, only the smartest investors are going to have a shot to potential profit from legal cannabis' growth. In particular, marijuana stock investors are going to have to keep their eyes on the following two critical data points for each and every marijuana stock they're considering buying, or that they already own. Otherwise, they risk losing their investment to foolishness (with a lowercase "f'").
With most marijuana stocks in expansion mode of some variety, either boosting production capacity or expanding clinical studies of an experimental cannabinoid-based drug, it's first and foremost important that they have enough working capital to cover their financial needs.
Working capital is simply a measure of the company's current assets minus its current liabilities. We're looking for a positive number here, because a negative number indicates that a company may not have enough assets to cover its short-term obligations, such as debt.
A potentially more useful working capital measure is the working capital ratio, which is expressed by the following formula:
Usually, companies that have twice the assets as liabilities are in pretty good shape, although this "ideal" figure can differ a bit depending on the industry. The important thing here is that the figure is well over 1, implying plenty of short-term liquidity and stability.
Why pay such close attention to working capital with marijuana stocks? Two reasons. First, with the exception of the publicly traded Canadian medical-cannabis companies, pot stocks are losing money hand over fist. Working capital should give investors some idea of whether a marijuana stock can reasonably expand its operations without going bankrupt or running into serious financial issues in the short term.
Second, "next big thing" investments like marijuana tend to lead companies to spend frivolously, which can cause short-term liquidity issues. We saw it with the dot-com boom, and we could be seeing it again with the green rush. Working capital helps investors take those short-term liabilities into account should a business lean heavily on debt-financed expansion.
As an example, I'd be seriously concerned about Axim Biotechnologies (NASDAQOTH: AXIM), a clinical-stage cannabinoid-based drug developer with more than a dozen preclinical and clinical trials listed on its website. The company's second-quarter report lists just $4.43 million in assets and $7.84 million in total liabilities. Even if we just look at just current liabilities, that's still $4.93 million. Axim could struggle to gather the funding it needs to run its studies, which should be a big concern for shareholders.
The other important figure that all pot stock investors need to know is a company's cash flow.
As noted, most marijuana stocks are losing money right now, but that doesn't necessarily mean they're in terrible financial shape as long as they're cash flow positive, or they have the working capital to withstand a cash outflow. Cash flow describes the difference between the money flowing in and the money going out. If more goes out than comes in, a company is cash flow negative, and vice versa if more is coming in than heading out. Considering the exceptionally high capital needs of expanding pot companies, cash flow will help tell a tale for investors about whether a company's available cash and working capital are being replenished over time.
For example, Canadian medical cannabis producer and retailer Aphria (NASDAQOTH: APHQF) ended its latest fiscal year (May 31, 2017) with $138.6 million in working capital, $65.5 million in cash and cash equivalents on its books, and $259.1 million in total assets compared with just $8.5 million in current liabilities. Scratching the surface, Aphria looks well-capitalized and has no short-term financial liquidity concerns.
However, it did see $51 million in negative free cash flow last year, primarily as a result of its heavy investment in capacity expansion. The company is currently working on a phase 4 expansion that'll boost its growing capacity more than threefold to 1 million square feet. This capacity expansion is deemed prudent given its ability to export cannabis to foreign markets, as well as the possibility that Canada legalizes adult-use weed next year.
Nevertheless, a few more years of negative cash flow to the magnitude of $51 million could put Aphria in a bind. To be clear, the company is in great financial shape now, but it's going to need to see returns on its investments beginning in 2018 or 2019 before investors consider pushing its valuation even higher.
If you're going to consider investing in marijuana stocks, you need to keep a close eye on working capital and cash flow if you plan to be successful.
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